The Cost of Loyalty

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For Merck & Co., one trigger was the withdrawal of Vioxx from the market. For Marsh & McLennan Cos., it was news that New York State Attorney General Eliot Spitzer had launched an investigation into alleged bid-rigging. And for Delta Air Lines Inc., it was simply investors’ belief that management had mismanaged the company.

The result for all three companies, however, was the same: after their stock price fell precipitously, employees hit them with class-action lawsuits citing breach of fiduciary duty related to company share-purchase provisions in their 401(k) plans.

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Arguably, these legal situations never should have arisen. Ever since the Enron debacle, in which employee retirement accounts collectively lost more than $1 billion, workers have been warned about the downside of putting 401(k) money solely in their company’s stock. But, according to Hewitt Associates, the practice is alive and well. In fact, some 84 percent of the 220 employers Hewitt surveyed that offer company stock in their 401(k) plans permitted employees to invest their contributions in it. And on average, employees who held that stock had 41 percent of their balances solely in those shares.

That lack of diversification, says H. Douglas Hinson, a partner at Atlanta-based Alston & Bird LLP, has led to some 50 class-action suits seeking retribution for 401(k) losses suffered since the stock-market bubble burst. Settlement amounts are enough to give companies pause. Last December, Lucent paid $69 million in a 401(k) class-action case. In May, Enron reached the biggest settlement so far, giving $85 million to current and former employees.

And the trend shows no sign of abating, even though the Employee Retirement Income Security Act (ERISA), which regulates 401(k) plans, neither prohibits the offering of company stock in plans nor requires employers to mandate diversification. The challenge for companies, says Jeffrey D. DuFour, CEO of Tillit Group LLP, a Princeton, New Jersey-based fiduciary consulting firm, is to “better match up [employees’] expectations with reality.” Otherwise, this may be only the first wave of legal actions. While many of the current cases reflect “bad behavior” on a corporate level, he explains, “when baby boomers figure out that they don’t have enough money to retire, those cases may instead be tied simply to how well participants’ portfolios do,” regardless of how much employers’ stock is in their plans.

Fiduciary or Shareholder Guardian?

One reason for the suits is that there is no legal precedent to control them. “These cases are so new that there’s not a lot of law developed yet,” says Hinson, now engaged by Mirant Corp. and BellSouth Corp., both Atlanta-based, to fight 401(k) class-action suits.

Such suits in general haven’t resulted in any court trials, or even summary judgments, in the past few years. Most of the legal rulings handed down since Enron’s collapse have addressed motions to dismiss at the district-court level, and only two have gone on to appeal. In those cases — Wright v. Oregon Metallurgical Corp. and LaLonde v. Textron Inc. — federal circuit courts split over whether to allow the litigation to proceed. And neither decision determined what should trigger a fiduciary’s duty to stop investing employees’ assets in company stock.

To Hinson, it’s clear “the plaintiffs’ lawyers are winning the initial skirmishes.” The absence of clear legal parameters, he explains, creates something of a free-for-all. “Any time you see a public company’s stock fall, there will be plenty of lawyers rushing to court,” he says. The cases remind him of securities class-action suits before The Private Securities Litigation Reform Act of 1995. Without any guidelines from the courts or Congress, the first lawyers filing tend to reap the most rewards.

Filing is a “cut-and-paste job” for the most part, adds Hinson. Plaintiffs complain that “the fiduciary should have removed company stock [from the 401(k) plan], and that the fiduciary knew something about the company’s prospects that should have been disclosed.” In the Mirant case, for example, the bankrupt energy marketer is accused of crafting a 401(k) plan intended to entice employees to buy company stock, rather than to maximize investment returns.

The cases highlight the dual role that CFOs and other executives play as fiduciaries of 401(k)s and overseers of the corporate stock. “Employers are in a really difficult situation,” says Alicia Munnell, Peter Drucker Professor of Management at Boston College. “If they have material information and they don’t say or do anything, they are potentially opening themselves up to a lawsuit. If they do disclose, they could be giving away trade secrets.”

Employees can sue even if CFOs or others aren’t trustees of the 401(k), says Hinson. In 2003, court ruled, for example, that former Enron CEO Kenneth Lay could be sued for personal liability for the company 401(k) plan even though he was not a trustee. (The case is still pending.) So by extension, says DuFour, “all senior executives have responsibility for overseeing the plan.” While Enron may be an egregious case, “this is a complex issue,” says Joseph D. Olivieri, senior manager for human-resources services at PricewaterhouseCoopers in Philadelphia. “If a CFO appoints the plan trustees, he could be a fiduciary by virtue of that function, even though he [is] not serving directly.”

The Non-Cash-Match Catch

At the root of it all, of course, is the employer’s decision to offer company stock as a 401(k) option, and/or match their employees’ contributions with company stock. “There is absolutely no good reason to use employer stock in 401(k) plans,” insists Munnell. Except that employers like the option of matching contributions without putting up cash.

And employees? They love it. “Many have seen numerous [executives and other employees] get wealthy holding on to company stock,” says Lori Lucas, director of participant research at Hewitt Associates. “Consequently, they almost view it as a lottery ticket.”

Why hasn’t that view changed in the wake of so many scandals? “When you drill down,” says Lucas, problems with Enron and others are seen as unique, and are not “extrapolated to anything that could happen to their company.” In other words, “familiarity leads participants to be more confident in their own company,” she explains.

Moreover, inertia rules. Even when employers authorize changes — easing the sale of employee holdings — there’s resistance. Some 36 percent of firms investing matching contributions in company stock now allow employees to diversify out of employer-match shares, up from 15 percent in 2001, Hewitt says. But, says Lucas, “there has been very little reaction to this by participants. It’s been a nonevent.”

So far, Congress has also been a no-show on the issue. After Enron’s collapse, there was debate on Capitol Hill on how to prevent employees from holding too much company stock in their portfolios. But nothing tangible ever materialized, nor is anything on the horizon.

Companies do have ways of protecting themselves, however. Policy documentation is a good place to start. If it’s surprising that so many companies allow investment in employer stock, it’s somewhat shocking that some offer employees no way out of their positions. “Any company that still has those policy issues in place is asking for trouble,” says DuFour. He recommends that companies matching contributions with stock allow employees to elect non-company-share matches instead, letting them sell off company-share matches over time. And “companies need to document the reasoning behind any policy change,” says PwC partner Stephen Metz. “Very often what hangs people in court is that they can’t show how they weighed the pros and cons of a particular policy decision.”

Education is also crucial. Even now, “employees just don’t understand diversification,” states DuFour. The offering booklets and seminars on the subject are clearly not enough. Instead, despite the cost, one-on-one education may be necessary to avoid legal liabilities in the future, he says. And training should not be limited to employees. Although ERISA doesn’t require education for plan trustees, “the prudent CFO or CEO should be sure those trustees have some idea of what they should be doing,” he says.

Others suggest more-drastic measures. “The way to solve this problem,” says Munnell, “is to diffuse it by getting employees to invest automatically in broad-based indices,” even though Labor Department rules would have to be changed. In addition, says Matthew Lee Wiener, a partner at law firm Dechert LLP, companies should follow the lead of Sprint Corp., Quest Communications Inc., and Duke Energy Corp., and hire outside fiduciaries. Having a third party oversee the 401(k) plan “might not eliminate the suits, but it would drastically change the landscape,” he says.

To date, most settlements have been covered by fiduciary liability insurance — although former Enron directors agreed to pay $1.5 million on their own. Still, the insurance will do nothing to stop the lawsuits. “As soon as something happens to a stock,” says Munnell, “employees assume that employers knew, and they sue.” No matter “how forearmed and forewarned” employees are, adds Metz, “they will always feel aggrieved if something goes wrong.”